HBOS: the Horse That Bolted
In 2001 the former Halifax building society which had turned itself into a bank merged with the Bank of Scotland to form HBOS. In October 2008 HBOS failed and was merged with Lloyds Bank in which the government took a major share. The Bank of England and the new Financial Conduct Authority have now issued a 400-page report on The Failure of HBOS PLC (HBOS).
The Report says that HBOS made some unwise lending decisions, investing disproportionally in commercial property and stakes in businesses (hindsight is such a benefit). Even currency cranks who think that banks have the power to conjure up the money they lend out of thin air concede that a bank can get into trouble by making bad loans. What they cannot accept is that a bank can also fail through not being able to secure the funding behind its loans. Some currency cranks (those who think that for a deposit of £100 a bank can lend many times that amount) accept, it is true, that if deposits fall a bank has to cut its lending, but not that every loan has to be funded. The Report, however, takes it for granted that this has to be the case. In his Foreword Andrew Bailey, one of the Bank of England’s Deputy Governors, says that the Report is
‘the story of an institution that became unsustainable through its poor risk management, in respect of the credit risk on the assets side of its balance sheet, and on the liabilities side in respect of the vulnerability of its funding. These are, of course, the fundamental building blocks of banking’ (emphasis added).
Those running a bank have to ensure both that the loans they make will be repaid and that the source of funding for these is secure. As essentially financial intermediaries, banks get their income from borrowing money at one rate of interest and re-lending it at a higher rate.
Accessing ‘wholesale financial markets’
After the merger, the Report says, HB0S pursued a policy of rapid growth, aiming to make a return on its capital of 20 percent. This involved increasing its lending but to do this it had also to increase its funding. Banks have two main sources of funding: what is deposited with them (in the jargon ‘retail’ borrowing) and the money market (‘wholesale’ borrowing). Deposits from customers are considered safer but they cannot be increased at will, if only because of competition for them from other banks and from building societies. It is easier to have recourse to the money market, i.e. borrowing from other banks and financial institutions. This is considered more risky because the interest rate is less predictable – if this goes up it squeezes the margin between the rate a bank borrows at and the rate at which it relends – and in a financial crisis can dry up.
To try to grow more in pursuit of greater profits, HBOS had increasing recourse to the money market:
‘The rapid expansion of its balance sheet placed pressure on HBOS’s ability to fund itself. HBOS’s retail funding struggled to keep pace with the Group’s lending growth, with customer deposits growing at an average annual rate of 5% a year during the Review Period, compared with a customer loan growth rate of 10%. As a result, HBOS increasingly accessed wholesale financial markets as a source of funding, raising its wholesale borrowing from £187 billion at the end of 2004 to £282 billion at end-2007.’
Bankers and their regulators use as a measure of a bank’s dependence on the money market the ‘loan-to-deposit ratio’ (which some currency cranks misunderstand as a measure of how much a bank can lend without having to cover it with funding, whereas it is actually a measure of what proportion of loans are covered by ‘wholesale financial markets’ over and above what is covered by customer deposits). The Report says that by 2008 HBOS’s loan-to-deposit ratio had reached 192 percent; in other words, it was lending nearly twice as much as its deposits, the rest coming from ‘wholesale financial markets’. This, the Report notes, was second only to that of Northern Rock.
When the financial crash came and the money market froze HBOS, like Northern Rock, couldn’t renew its borrowing from it except at impossibly high rates and so couldn’t renew the coverage for all its loans, with the result, the Report records, that:
‘By the end of September 2008, HBOS was no longer able to meet its needs from the wholesale market and was facing a withdrawal of customer deposits.’
Yet another example of how the Report, written by practical bankers, takes for granted that a bank ‘needs’ to have funding for its loans. No nonsense here about a bank being able to conjure money to lend out of thin air since, of course, if it could, why would it need to go the money market to try to get funding? On 1 October HBOS was bailed out by the Bank of England.
The new paradigm that wasn’t
The top management of HBOS may well have taken more risks than most of its rivals but at the time they were acting as profit-seeking, capitalist enterprises always do in a boom – assuming that it will continue. In his Foreword Bank of England Deputy Governor Andrew Bailey writes that ‘both the strategy and operation of HBOS, and its supervision by the FSA, were creatures of the time’ and that what happened took place ‘against the backdrop of almost uninterrupted growth over a long period and the rapid development of financial markets’. The Report elaborates:
‘Halifax and Bank of Scotland merged during a period of heightened corporate activity, in the middle of an economic cycle that had begun in the early 1990s. UK domestic economic growth had been relatively steady since the recession of the early 1990s, resulting in an extraordinarily long period (around 60 quarters) of continuous expansion. The growth in the financial services sector was more than twice as fast as the economy as a whole, averaging 6% per annum in the decade preceding the crisis, and increasing its share of nominal gross domestic product (GDP) to around 10%. Confidence in the future prospects of the economy was reflected in both bank and non-bank equity prices, which rose steadily from the start of 2003 until 2007. As the benign conditions persisted for longer and longer, many perceived that a new paradigm of economic stability had been established. ‘
One of the many who ‘perceived’ this, in fact shouted it from the rooftops, was of course Gordon Brown who, as Chancellor, proclaimed the end of the boom/slump cycle. He even recommended HBOS’s chief executive, James Crosbie, for a knighthood. When the crash finally came, and exposed him as a latter-day King Canute who imagined that he could command how the capitalist economy worked, he had become Prime Minister.
Andrew Bailey writes that ‘the criticism in the Report is not that management failed to predict that there would be a global financial crisis’ but in effect that’s it what it is. How else does he expect a commercial bank, which is a profit-seeking capitalist enterprise like any other, engaged in a particular business activity, to have acted in conditions that were ‘benign’ for profit-making? To have held back and let its competitors gather more of the hay while the sun shone? He must have more experience of how capitalism works than to be that naïve. HBOS did not become ‘unsustainable through its poor risk management’ but because the boom ended. If the boom hadn’t ended HBOS would have survived and no doubt more knighthoods would have been handed out.
The story of the rise and fall of HBOS is a particular case of how all capitalist firms behave when faced with profit-making prospects they ‘perceive’ are going to continue. They go for it but have to face the consequences when, as a result of the collective activity of all the competing firms involved, these conditions come to an end due to overproduction (or, in case of banks, over-lending). It’s happened many times before under capitalism and is a regular feature of the system. It will happen again, even in the field of banking despite the regulations now being put in place after the horse has bolted.